Thursday, February 5, 2009

Will Companies Defuse Pensions Time Bomb?

Mr. Harrison appeared on Tech Ticker earlier today stating that his gut feeling is the market will move up and he is ready to deploy cash. He bought back some Yahoo (YHOO) and he is long some financials and nibbling on energy despite the deflationary headwinds.

However, Mr. Harrison emphasized prudence, discipline and risk management as well as the importance of "not trading". He obviously knows all about Boy Plunger's pivotal point theory.

With earnings season half over, it's not just the huge write-offs and plunging profits that have investors on edge. More and more companies are so uncertain about the future they're simply unwilling to commit to earnings forecasts at all.

That reluctance is making the market increasingly skittish, and in January the Dow Jones industrial average turned in the worst performance in its 113-year history.

"Every company that we talk to across every industry, and this includes healthy ones, have basically burrowed themselves as far as they can in the foxhole," said Marc Harris, co-head of global research at RBC Capital Markets.

Results from the first 227 companies in the Standard & Poor's 500 index to report results are worrisome. Sales fell 10.2 percent in the October-December period, according to S&P. The companies lost an average of $8.89 a share mainly because of huge write-offs. Corporations are recording the write-downs now partly so results can look better in future quarters.

"Companies are not only throwing in the kitchen sink, they're throwing in the refrigerator," said Howard Silverblatt, senior index analyst at Standard & Poor's. "Kitchen sinking" is a Wall Street term for compressing charges and write-downs into a single earnings period.

Wall Street knew the fourth-quarter results would be awful after consumers and businesses curtailed their spending in the fall. But the increasing hesitation to predict what's next is adding to the market's already deepening sense of unease.

"The numbers are bad. So you've got the estimates coming down," said Quincy Krosby, chief investment strategist at The Hartford, referring to analysts' forecasts for the coming quarters. "The main thing is the lack of guidance. The companies are stymied by the macroeconomic conditions and the deterioration of those fundamentals."

It was only a matter of time before those lofty earnings estimates from analysts and strategists were going to come crashing back down to earth as the S&P500 veers into the red:

Corporate profits are tumbling, but could earnings for the mighty S&P 500 actually dip into the red in the fourth quarter?

According to Standard & Poor's, the possibility is very real. It would mark the first time that the index - the most widely followed in the world and a collection of the 500 biggest companies in the United States - has produced a loss in its aggregate earnings.

Yes, financials reported another dismal quarter, with losses approaching $50-billion (U.S.) in total. But the losses are more widespread now, with the downturn in the U.S. economy hitting nearly every sector.

Based on earnings for the 244 companies that have reported their fourth-quarter results so far, representing about 65 per cent of the market value of the index, Mr. Silverblatt said that aggregate earnings are on track to fall to a loss of $1.65 a share, with revenues falling nearly 11 per cent.

By comparison, earnings fell as low as $3 a share during the fourth quarter of 2002, when the U.S. stock market was still reeling from a terrible bear market that followed the implosion of the dot-com bubble two years earlier. Before then, you would have to go all the way back to 1938 to find a worse quarter - but even then, the S&P 500 managed to stay in the black, with earnings of 11 cents.

To be sure, one of the reasons for the loss during the quarter is the fact that companies have reported extraordinary charges related to writedowns and layoffs. For example, ConocoPhillips Co. reported a $31.8-billion loss in the fourth quarter, related largely to a goodwill writedown.

"To some extent, it is typical in down years to junk everything into the fourth quarter," said Marc Pado, chief market strategist at Cantor Fitzgerald. "If you're going to lay off workers and you're going to cut your dividend, you want to make that number look as ugly as possible. In this environment, it's probably more intentional to write down inventories than it would otherwise be."

Optimistic investors would likely take this as a sign that the fourth quarter is as bad as things will get. Indeed, using operating earnings, rather than reported earnings, the situation isn't quite as grim: S&P 500 companies reported aggregate earnings of $8.10 a share - down more than 40 per cent from last year, but at least above water.

Still, the dip suggests that analysts and strategists remain out of sync with reality. According to Bespoke Investment Group, analysts had been expecting that fourth-quarter earnings would rise 30 per cent over the fourth quarter of 2007. By early January, those expectations had been revised from a 30-per-cent rise to a 28-per-cent drop.

Meanwhile, stock market strategists believe that the S&P 500 will rise, on average, by nearly 17 per cent in 2009 - a forecast that looks remarkably sunny given the onslaught of grim economic news and the fact that the index is down for the year so far.

"This quarter can't be better," Mr. Silverblatt said. "Layoffs are scaring the heck out of everybody."

This just in: The Standard & Poor’s 500 is on its way to the first quarter it has had — the data goes back to 1936 — in which the companies in it will report overall losses rather than profits.

Howard Silverblatt, S.&P.’s index maven, reports that with almost three-quarters of the companies in the index having reported fourth-quarter numbers, the loss per S.&P. share is now $6.32. Most of that is write-offs, not operating losses, of course, and over all the companies are reporting operating profits. But the write-offs are not just in the banks. Time Warner’s big hit for writing off its AOL folly is one example.

(A note on how that profit is calculated. The losses and profits of the companies are weighted in the same way the index is, so Exxon Mobil’s profits count for a bigger share than do anyone else’s earnings. To get a price/earnings ratio for the S.&P. 500, take the 12-month profit number — on an as-reported basis it would be $31.81 for all of 2008 if the rest of the companies left to report do not change the fourth-quarter figure. So the P/E would be about 27.)

Some of the largest losses came from two banks that wrote off a lot of stuff on their way to being acquired — Merrill Lynch and Wachovia.

The biggest contributor to the S.&P. loss, however, was an oil company, ConocoPhillips. It took big write-offs on good will and in an investment in Russia.

Companies are struggling to plug gaping holes in their crisis-scarred pension schemes, risking costly downgrades in already tight credit markets and creating a wildcard for profits this year.

Analysts will be scrutinising anything employers have to say on an estimated pension deficit of 75 billion pound across the largest 50 multinationals in Europe, as the value of assets accrued by the schemes sags.

"Pension deficit is a debt, but it is a very variable debt that can change quite considerably. If you tweak a few assumptions it can go up or down," said Gerd Zonneveld, a transport analyst at brokerage Panmure Gordon.

Global pension assets fell 18 percent to $25 trillion (17.6 billion pounds) in 2008 from $30.4 trillion a year earlier, the largest decline for years, industry body the International Financial Service London said on Monday.

Pensions are not normally a closely watched part of earnings statements, but they can make a huge difference when companies are already struggling with the downturn.

A pension shortfall at Canadian telecom equipment maker Nortel (NT.TO) was seen as one reason behind its recent entry into bankruptcy protection, while defence contractor Lockheed Martin (LMT.N) cut its outlook because of high pension costs.

Even if not weighing on a company's balance sheet, pension deficits -- which a company is obliged to rectify -- can prove a bone of contention in takeovers, like in British Airways' (BAY.L) intended merger with Iberia (IBLA.MC).

"We are very conscious of ... how they are going to fund those deficits," said Collins Stewart analyst Andrew Ritchie.

A pension deficit per se was no reason to downgrade a company, Ritchie said, but he added he was keeping an eye on how a company takes steps to tackle the deficit and to see if the pension scheme was recovering.

Rating agency Moody's recently warned that a further decline in pension assets in 2009 could "exert significant pressure on credit profiles," making it more expensive and difficult for a company to raise cash in already tight markets.

Europe's largest 50 companies could see their joint pension deficit rise to 200 billion pounds, if the yield on bonds used to calculate pension liabilities falls back to pre-credit-crunch levels, consultant Lane Clark & Peacock said.

Pension schemes are effectively creditors of a company, and some are drawing up contracts to give pension schemes special creditor status -- an arrangement that can antagonise other creditors, according to pension advisors.

A few employers are even considering benefits shakeups, replacing pension schemes with other benefits that carry no long-term liabilities.

"Companies are saying: Whatever we do, we must avoid the pension scheme going below a certain amount or we will be re-rated", said Matt Wilmington, a senior pension adviser to companies at consultant Hewitt.

Even if they are not downgraded, some employers are not able to address the pension deficit by pledging assets -- because the promise itself would impact their chances of getting credit.

They are likely to resist calls for extra funds at least in the short term, said Deborah Cooper, principal at consulting firm Mercer, something that is allowed to a certain degree in some jurisdictions such as the Netherlands.

Other countries such as the UK or Ireland do not permit the practice, though in the UK, both pension fund trustees and regulators have been willing to give sponsors more time to make the deficit good, she said.

"Most regulatory frameworks in Europe are flexible and we have to expect employers to push the flexibility to the limit," Cooper said. "There will always have to be some sort of pension provisions, but it makes sense to be more creative."

The anomaly has come about as a result of the sharp widening of AA-rated corporate bond spreads above government bonds in the wake of the credit crisis.

Since the credit crisis began, AA-rated corporate bonds have yielded as much as 290 basis points above gilts.

Under current accounting rules pension schemes have to calculate their liabilities using a discount rate generally based on AA-rated corporate bond yields. A higher yield results in lower liabilities and consequently lower deficits.

Clive Fortes, head of corporate consulting at Hymans Robertson, said on Wednesday the current 2 percent spread above government bonds did not reflect their AA-rating.

Accountancy firm Deloitte in October last year said it was advising some pension fund clients to base calculations of future pension payments only on corporate bond yields of non-financial institutions to reflect their true values.

Hymans' Fortes said: "In the coming months, it will be interesting to see if scheme trustees ask their sponsors for more cash to fund deficits - and whether this has a negative effect on UK Plc's ability to climb out of recession."

Hymans' report said 40 percent of FTSE 350 companies will likely be forced to address their pension burden in 2009 either by injecting cash or cutting benefits.

Overall the consultant said the problems facing schemes are manageable and the proportion of companies likely to go insolvent as a result of its pension scheme will be a minority.

Industrials and retail sector companies have the heaviest pensions burden at present while financial companies' pensions are in comparatively strong positions, Hymans said.

U.S. pension funds are projecting sharply reduced investment returns from major asset classes, including alternatives, through 2013, according to new research from Greenwich Associates.

Overall, more than 1,000 U.S. corporate pension funds interviewed from July to October 2008 said they had reduced investment returns on plan assets to an annual 7.4% in 2008 from 8.2% in 2007, and public funds cut their overall portfolio return expectations to 7.6% from 8.5%.

Both groups expected private equity to generate the highest returns of any asset class over the next five years, with public funds projecting an annual 11.3% return from their private equity investments and corporate funds expecting 10.1%.

“It is important to remember the extent to which markets have deteriorated since these interviews were completed in September,” says Greenwich consultant Dev Clifford. “If anything, these expectations for private equity and other asset classes might prove overly optimistic.”

Pension funds have dramatically reduced return expectations for U.S. equities, with projections for annual rates of return dropping to 7.8% in 2008 from 8.6% in 2007 among corporate plans and to 7.9% from 9.1% among public plans.

Both groups also cut return expectations on fixed income and pension funds also reported substantial reductions in expected returns on international equity, equity real estate, private equity and hedge funds.

British private equity firm Alchemy Partners' Jon Moulton presided over a particularly gloomy poll on the last day.

Asked which private equity investments would perform best, 42 percent of the audience said "distressed" while only 3 percent voted for large buyouts.

"That demonstrates what's happened," said Moulton. "Leverage is out of fashion."

Over 80 percent thought there would be a "bloodbath" in LBO defaults in the next year in Europe, 52 percent thought less money would get committed to private equity and 17 percent thought there would be a "substantial extinction" of large buyout firms, with a further 46 percent thinking that 16-25 percent of firms would go to the wall.

MetLife Inc, the No. 1 U.S. life insurer, said on Wednesday it may write down some investments in large private equity funds during the first half of 2009.

"It is probably fair to say that there will be some marks on those portfolios and some impairments," Chief Investment Officer Steve Kandarian said on an investor call, a day after MetLife reported better-than-expected fourth-quarter operating income.

He said while 2008 figures were still being compiled by firms, market checks indicated larger funds suffered the most from frozen credit markets.

Private equity firms, gathered for an industry meeting this week in Berlin, have said they are being forced to dive into alternative investments or sit on the sidelines as the credit crisis kills their ability to strike the profitable leveraged buyouts for which they are famed.

Kandarian said the value of large fund investments may have fallen between 10 percent and 20 percent, citing difficulties in spinning off portfolio businesses to public and private investors, given credit market conditions.

The insurer does not yet have a figure for how large its own impairments could be from these investments.

Kandarian, who manages MetLife's $322.5 billion investment portfolio, said its overall investment in private equity funds was about $3.1 billion, with about $1.2 billion in larger funds.

MetLife Inc., the largest U.S. life insurer, said fourth-quarter profit declined 12 percent on losses from hedge funds and real estate ventures. Shares gained in extended trading as the company beat analysts’ estimates.

Net income slipped to $985 million, or $1.20 a share, from $1.12 billion, or $1.44, in the year-earlier period, the New York-based insurer said today in a statement. Excluding some investment results, the company made 19 cents a share, six cents better than the average estimate of 17 analysts surveyed by Bloomberg.

MetLife joins Allstate Corp., Chubb Corp. and Travelers Cos. in posting losses on so-called alternative investments, as hedge funds lost a record 18 percent last year. MetLife’s alternative holdings underperformed company targets by $540 million in the quarter ended Dec. 31. The firm said in 2007 that quarterly returns from the assets would be about $305 million.

“The most challenging economic environment we have experienced in decades” weighed on results, Chief Executive Officer Robert Henrikson said in the statement.

Henrikson braced for a deepening U.S. recession and an increase in corporate-bond defaults by selling $2.3 billion in new stock in October and stockpiling cash. That bolstered MetLife’s finances and may allow the company to bid for money- losing rivals as investment losses accumulate across the industry.

Transaction sale prices of commercial property sold by major institutional investors fell by more than 10 percent -- a record -- in the fourth quarter of 2008, according to an index developed and published at the MIT Center for Real Estate that also posted a record 15 percent drop for the year.

The 10.6 percent drop in the transactions-based index (TBI) for the fourth quarter is the largest quarterly decline in the gauge's history, which dates to 1984. The previous record was a 9 percent drop in the fourth quarter of 1987. The 15 percent fall in 2008 is also a record, topping the 10 percent and 9 percent declines in 1992 and 1991, respectively.

The index's performance means that prices in institutional commercial property deals that closed during the fourth quarter for properties such as office buildings, warehouses and apartment complexes are now 22 percent below their peak values attained in the second quarter of 2007. The index has fallen in five of the past six quarters, but the recent drop is by far the steepest.

"With the index already having fallen 22 percent in the current downturn, it now seems likely that this down market will be at least as severe as that of the early 1990s for commercial property," said Professor David Geltner, director of research at the Center for Real Estate.

In the last major downturn in the U.S. commercial property market 20 years ago, the TBI declined a total of 27 percent from 1987 through 1992, with most of that drop occurring in 1991-92. "Nevertheless, a decline of 22 percent compares favorably to the stock market, which has lost more than 40 percent over the same period, including 20 percent in the last quarter," Geltner noted.

The MIT/CRE publishes not only the price index based on closed deals, but also compiles indices that separately gauge movements on the demand side and the supply side of the market that it tracks. The demand-side index tracks the changes in prices that potential buyers are willing to pay (sometimes called a "constant-liquidity" index of the market, because it tracks how much prices would have to change to keep a constant ability to sell as many properties at the same rate of trading volume).

That index has now fallen steadily for all of the past six quarters, dropping again in the third quarter by 10.3 percent, and is down 23 percent for the year and 31 percent since its mid-2007 peak.

"The results posted by our index are corroborated by recent evidence from another commercial property price index whose methodology was developed at the MIT/CRE, the Moody's/REAL Index produced by Moody's Investors Service," said MIT/CRE Principal Research Associate Henry Pollakowski, noting that Moody's December results were scheduled to be published Feb. 19.

"This index showed a sharp decline in its latest monthly report, for November, placing that broader index of realized commercial property prices at 15 percent below its 2007 peak, even before the end of the year."

The TBI tracks the prices that institutions such as pension funds pay or receive when transacting commercial properties like shopping malls, apartment complexes and office towers.

The MIT Center's TBI is based on prices of National Council of Real Estate Investment Fiduciaries (NCREIF) properties sold each quarter from the property database that underlies the NCREIF Property Index (NPI), and also makes use of the appraisal information for all of the currently 6,000 NCREIF properties.

Such an index -- national, quarterly, transaction-based and by property type -- had not been previously constructed prior to MIT's development of it in 2006. NCREIF supported development of the index as a useful tool for research and decision-making in the industry.

I will leave you with something else to think about. Unless stock markets come back strongly, there is no way that private equity will deliver double digit returns.

If double digit private equity returns are what corporations are banking on, the pensions time bomb will blow them straight into bankruptcy.

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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